**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**                                                                                                                                                                             | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                              |
| **For the quarterly period ended March 31, 2008**                                                                                                                            |
|                                                                                                                                                                              |
| **OR**                                                                                                                                                                            |
|                                                                                                                                                                              |
| **o**                                                                                                                                                                             | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                              |
| **For  the transition period from              to           ** |
|                                                                                                                                                                              |
| **Commission File Number   0-20191**                                                                                                                                         |

 

**INTRUSION INC.**

(Exactname of small business issuer as specified in its charter)

 
| **Delaware**                                                     | ** ** | **75-1911917**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

**1101 East Arapaho Road, Suite 200, Richardson, Texas75081**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Issuer’stelephone number, including area code)

 

**Not Applicable**

Formername, if changed since last report)

 

** * * * * * * * *

 

Check whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days:

Yes x No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| Large  accelerated filer o                     |   | Accelerated  filer o         |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                       |   | Smaller  reporting company x |
| (Do  not check if a smaller reporting company) |   |                              |

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act:  Yes o No x

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on April 30,2008 was 11,638,405.

 

Transitional Small BusinessDisclosure Format (check one):  Yes o No x

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I –  FINANCIAL INFORMATION**                                                                       |   |
|---------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                |   |
| Item 1.  Financial Statements                                                                                       |   |
|                                                                                                                |   |
| Unaudited  Condensed Consolidated Balance Sheets as of March 31, 2008 and  December 31, 2007              |   |
|                                                                                                                |   |
| Unaudited  Condensed Consolidated Statements of Operations for the three months ended March 31, 2008 and 2007  |   |
|                                                                                                                |   |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the three months ended  March 31, 2008 and 2007 |   |
|                                                                                                                |   |
| Notes to Unaudited Condensed Consolidated Financial  Statements                                                     |   |
|                                                                                                                |   |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                 |   |
|                                                                                                                |   |
| Item 4. Controls and Procedures                                                                                     |   |
|                                                                                                                |   |
| **PART II  – OTHER INFORMATION**                                                                          |   |
|                                                                                                                |   |
| Item 1A. Risk Factors                                                                                               |   |
|                                                                                                                |   |
| Item 6. Exhibits                                                                                                    |   |
|                                                                                                                |   |
| Signature  Page                                                                                                     |   |

 

2

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**PART I – FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                          | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                          |       |                     |       |                        |       |
| Current Assets:                                                                                                     |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                           |       | $                        | 93         |                        | $          | 362 |   |
| Accounts receivable, less allowance for  doubtful accounts of $40 in 2008 and 2007                                  |       | 163                      |       | 110                         |       |
| Inventories, net                                                                                                    |       | 123                      |       | 146                         |       |
| Prepaid expenses                                                                                                    |       | 63                       |       | 75                          |       |
| Total current  assets                                                                                               |       | 442                      |       | 693                         |       |
| Property and equipment, net                                                                                         |       | 132                      |       | 144                         |       |
| Other assets                                                                                                        |       | 39                       |       | 39                          |       |
| TOTAL ASSETS                                                                                                        |       | $                        | 613        |                        | $          | 876 |   |
|                                                                                                                |       |                     |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                     |       |                     |       |                        |       |
|                                                                                                                |       |                     |       |                        |       |
| Current Liabilities:                                                                                                |       |                     |       |                        |       |
| Accounts payable and accrued expenses                                                                               |       | $                        | 695        |                        | $          | 688 |   |
| Line of credit                                                                                                      |       | 14                       |       | 100                         |       |
| Loans payable to officer                                                                                            |       | 705                      |       | —                      |       |
| Deferred revenue                                                                                                    |       | 333                      |       | 312                         |       |
| Total current liabilities                                                                                           |       | 1,747                    |       | 1,100                       |       |
|                                                                                                                |       |                     |       |                        |       |
| Stockholders’ Deficit:                                                                                         |       |                     |       |                        |       |
| Preferred stock, $0.01 par value:  Authorized shares – 5,000                                                   |       |                     |       |                        |       |
| Series 1 shares issued and outstanding  — 260  Liquidation preference of $1,331 as of March 31, 2008 |       | 918                      |       | 918                         |       |
| Series 2 shares issued and outstanding  — 460  Liquidation preference of $1,169 as of March 31, 2008 |       | 724                      |       | 724                         |       |
| Series 3 shares issued and outstanding  — 354  Liquidation preference of $785 as of March 31, 2008   |       | 504                      |       | 504                         |       |
| Common stock, $0.01 par value:                                                                                      |       |                     |       |                        |       |
| Authorized shares — 80,000                                                                                     |       |                     |       |                        |       |
| Issued shares — 11,648                                                                                         |       |                     |       |                        |       |
| Outstanding shares — 11,638                                                                                    |       | 116                      |       | 116                         |       |
| Common stock held in treasury, at cost – 10  shares                                                            |       | (362                     | )          | (362                        | )          |
| Additional paid-in capital                                                                                          |       | 55,492                   |       | 55,527                      |       |
| Accumulated deficit                                                                                                 |       | (58,347                  | )          | (57,472                     | )          |
| Accumulated other comprehensive loss                                                                                |       | (179                     | )          | (179                        | )          |
| Total stockholders’ deficit                                                                                    |       | (1,134                   | )          | (224                        | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                    |       | $                        | 613        |                        | $          | 876 |   |

 

Seeaccompanying notes.

 

3

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**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS

(Inthousands, except per share amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                 | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007** | ** ** |
| Net product revenue                                                        |       | $                                | 299        |   | $ | 898 |   |
| Net customer support and maintenance  revenue                              |       | 163                              |       | 194 |   |
| Total revenue                                                              |       | 462                              |       | 1,092 |   |
| Cost of product revenue                                                    |       | 174                              |       | 403 |   |
| Cost of customer support and maintenance  revenue                          |       | 5                                |       | 18 |   |
| Total cost of revenue                                                      |       | 179                              |       | 421 |   |
|                                                                       |       |                             |       |   |   |
| Gross profit                                                               |       | 283                              |       | 671 |   |
|                                                                       |       |                             |       |   |   |
| Operating expenses:                                                        |       |                             |       |   |   |
| Sales and marketing                                                        |       | 371                              |       | 515 |   |
| Research and development                                                   |       | 516                              |       | 423 |   |
| General and administrative                                                 |       | 265                              |       | 227 |   |
|                                                                       |       |                             |       |   |   |
| Operating loss                                                             |       | (869                             | )          | (494 | ) |
|                                                                       |       |                             |       |   |   |
| Interest income (expense), net                                             |       | (6                               | )          | 2 |   |
|                                                                       |       |                             |       |   |   |
| Loss before income tax provision                                           |       | (875                             | )          | (492 | ) |
|                                                                       |       |                             |       |   |   |
| Income tax provision                                                       |       | —                           |       | — |   |
|                                                                       |       |                             |       |   |   |
| Net loss                                                                   |       | $                                | (875       | ) | $ | (492 | ) |
|                                                                       |       |                             |       |   |   |
| Preferred stock dividends accrued                                          |       | (40                              | )          | (43 | ) |
| Net loss attributable to common  stockholders                              |       | $                                | (915       | ) | $ | (535 | ) |
|                                                                       |       |                             |       |   |   |
| Net loss per share attributable to common  stockholders, basic and diluted |       | $                                | (0.08      | ) | $ | (0.06 | ) |
|                                                                       |       |                             |       |   |   |
| Weighted average common shares outstanding,  basic and diluted             |       | 11,638                           |       | 8,471 |   |

 

Seeaccompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Inthousands)

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **March 31,  2008**         | ** ** | **March 31,  2007** | ** ** |
| Operating Activities:                                                        |       |                             |       |   |   |
| Net loss                                                                     |       | $                                | (875       | ) | $ | (492 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                |       | 12                               |       | 17 |   |
| Provision for doubtful accounts                                              |       | —                           |       | (14 | ) |
| Stock-based compensation                                                     |       | 5                                |       | 8 |   |
| Changes in operating assets and  liabilities:                                |       |                             |       |   |   |
| Accounts receivable                                                          |       | (53                              | )          | 49 |   |
| Inventories                                                                  |       | 24                               |       | — |   |
| Prepaid expenses and other assets                                            |       | 11                               |       | 42 |   |
| Accounts payable and accrued expenses                                        |       | (33                              | )          | (216 | ) |
| Deferred revenue                                                             |       | 21                               |       | (16 | ) |
| Net cash used in operating activities                                        |       | (888                             | )          | (622 | ) |
| Investing Activities:                                                        |       |                             |       |   |   |
| Purchases of property and equipment                                          |       | —                           |       | (27 | ) |
| Financing Activities:                                                        |       |                             |       |   |   |
| Net activity under line of credit                                            |       | (86                              | )          | (75 | ) |
| Borrowings from officer                                                      |       | 705                              |       | — |   |
| Dividends paid on preferred stock                                            |       | —                           |       | (27 | ) |
| Proceeds from the issuance of common stock                                   |       | —                           |       | 500 |   |
| Net cash provided by financing activities                                    |       | 619                              |       | 398 |   |
|                                                                         |       |                             |       |   |   |
| Net decrease in cash and cash equivalents                                    |       | (269                             | )          | (251 | ) |
| Cash and cash equivalents at beginning of  period                            |       | 362                              |       | 933 |   |
| Cash and cash equivalents at end of period                                   |       | $                                | 93         |   | $ | 682 |   |
|                                                                         |       |                             |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                   |       |                             |       |   |   |
|                                                                         |       |                             |       |   |   |
| Preferred stock dividends accrued                                            |       | $                                | 40         |   | $ | 43 |   |

 

Seeaccompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.               Description of Business

 

We develop, market and support a family of entity identification,regulated information compliance, data privacy protection and network intrusionprevention/detection products.  Ourproduct families include:  TraceCopTMfor identity discovery and disclosure, Compliance CommanderTM for regulated information and dataprivacy protection, and Intrusion SecureNetTMt for network intrusion prevention and detection.  Our products help protect criticalinformation assets by quickly detecting, protecting, analyzing and reportingattacks or misuse of classified, private and regulated information forgovernment and enterprise networks.

 

We market and distribute our products through a direct sales force toend-users, distributors and system integrators, managed service providers andvalue-added resellers. Our end-user customers include banks, credit unions,other financial institutions, U.S. federal government entities, foreigngovernment entities and local government entities, high technology, e-commerceand telecommunication companies, hospitals and other healthcare providers andacademic institutions.  Essentially, ourend-users can be defined as ‘any end-users requiring network security solutionsfor protecting their mission critical data’.

 

We were organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we announced plans to sell, or otherwisedispose of, our networking divisions, which included our EssentialCommunications division and our local area networking assets. On June 1,2000, we changed our name from ODS Networks, Inc. to Intrusion.com, Inc.,and our ticker symbol from ODSI to INTZ to reflect our focus on intrusionprevention and detection solutions, along with information compliance and dataprivacy protection products. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

 

Our principal executive offices are located at 1101 East Arapaho Road, Suite 200,Richardson, Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM andTraceCopTM are trademarks of Intrusion Inc.

 

As of March 31, 2008, we had cash, cash equivalents andinvestments of approximately $0.1 million, down from approximately $0.4 millionas of December 31, 2007.  Netoperating losses and operating cash outflows may continue through the secondquarter of 2008 and possibly later into fiscal year 2008.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockwhich will reduce our available cash resources.   As of March 31, 2008 we had cash andcash equivalents of $93,000 and $31,000 available funding under our line ofcredit at Silicon Valley Bank and $1.5 million available from a writtencommitment to invest up to $1.5million from G. Ward Paxton, the Company’s Chairman, President and ChiefExecutive Officer.  We expect tofund our operations through additional investments of private equity and debt,which, if we are able to obtain, will have the effect of diluting our existingcommon stockholders, perhaps significantly. Any equity or debt financings, if available at all, may be on termswhich are not favorable to us and, in the case of equity financings, may resultin dilution to our stockholders. If our operations do not generate positivecash flow in the next few months, or if we are not able to obtain additionaldebt or equity financing on terms and conditions acceptable to us, if at all,we may be unable to implement our business plan, fund our liquidity needs oreven continue our operations.

 

2.               Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q and Item10-01 of Regulation S-X.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  The December 31, 2007balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generallyaccepted in the United States.  However,we believe that the disclosures are adequate to make the information presentednot misleading.  In our opinion, all theadjustments (consisting of normal recurring adjustments) considered necessaryfor fair presentation have been included. The results of operations for the three month period ending March 31,2008 is not necessarily indicative of the results that may be achieved for thefull fiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in our annual report on Form 10-KSB for theyear ended December 31, 2007, filed with the commission on March 28,2008.

 

6

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3.               Inventories (In thousands)

 
| ** **              | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|-------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                    |       |                     |       |                        |       |
| Inventories consist of: |       |                     |       |                        |       |
|                    |       |                     |       |                        |       |
| Finished goods          |       | $                        | 111        |                        | $          | 123 |   |
| Work in progress        |       | 8                        |       | 8                           |       |
| Demonstration systems   |       | 4                        |       | 15                          |       |
| Net inventory           |       | $                        | 123        |                        | $          | 146 |   |

 

4.               Accounting for Stock-Based Compensation

 

The Company recognized$5,000 and $8,000, respectively, stock-based compensation expense for the threemonth periods ended March 31, 2008 and 2007.

 

Valuation Assumptions

 

The fair values of option awards were estimated at the date of grantusing a Black-Scholes option-pricing model with the following assumptions:

 
| ** **                             | ** ** | **Three Months Ended  March 31, 2008** | ** ** | **Three Months Ended  March 31, 2007** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
|                                   |       |                                                       |       |                                                       |       |
| Weighted average grant date fair value |       | $                                                          | 0.17       |                                                       | $          | 0.49 |   |
| Weighted average assumptions used:     |       |                                                       |       |                                                       |       |
| Expected dividend yield                |       | 0.0                                                        | %          | 0.0                                                        | %          |
| Risk-free interest rate                |       | 2.6                                                        | %          | 4.75                                                       | %          |
| Expected volatility                    |       | 107.0                                                      | %          | 108.0                                                      | %          |
| Expected life (in years)               |       | 5.0                                                        |       | 5.0                                                        |       |
|                                        |            |                                                            |            |                                                            |            |  |  |

 

Expected volatility is based on historical volatility and in part onimplied volatility.  The expected termconsiders the contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward.

 

5.               Net Loss Per Share

 

Basic net loss per share iscomputed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share is computedby dividing the net loss attributable to common stockholders by the weightedaverage number of common shares and dilutive common stock equivalentsoutstanding for the period.  Our commonstock equivalents include all common stock issuable upon conversion of preferredstock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the diluted loss per share calculation for theperiods ended March 31, 2008 and 2007 are 4,248,628 and 3,920,674,respectively.  Our common stockequivalents are not included in the diluted loss per share for the three monthperiods ended March 31, 2008 and 2007, as they are antidilutive.

 

6.               New Accounting Pronouncements

 

In February 2008, FASB Staff Position (“FSP”) FAS No. 157-2, *Effective Date of FASB Statement No. 157*(“FSP 157-2”),was issued. FSP 157-2 defers the effective date of SFAS 157-2 tofiscal years beginning after December 15, 2008, and interim periods withinthose fiscal years, for all nonfinancial assets and liabilities, except thosethat are recognized or disclosed at fair value in the financial statements on arecurring basis (at least annually). Examples of items within the scope ofFSP 157-2 are nonfinancial assets and nonfinancial liabilities initiallymeasured at fair value in a business combination (but not measured at fairvalue in subsequent periods), and long-lived assets, such as property, plantand equipment and intangible assets measured at fair value for an impairmentassessment under SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*.

 

The partial adoption of SFAS 157-2 on January 1, 2008 withrespect to financial assets and financial liabilities recognized or disclosedat fair value in the financial statements on a recurring basis is not expectedto have a material impact on our consolidated financial statements. We are inthe process of analyzing the potential impact of SFAS 157-2 relating toour planned December 31, 2008 adoption of the remainder of the standard.

 

7

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In December 2007, FASB issued SFAS No. 160, *Non-Controlling Interests in Consolidated Financial Statements anamendment of ARB No. 51* (“SFAS 160”). SFAS 160establishes new standards for the accounting for and reporting ofnon-controlling interests (formerly minority interests) and for the loss ofcontrol of partially owned and consolidated subsidiaries. SFAS 160 doesnot change the criteria for consolidating a partially owned entity.SFAS 160 is effective for fiscal years beginning after December 15,2008. We do not expect the adoption of SFAS 160 will have a materialimpact on our consolidated financial statements.

 

Also in December 2007, FASB issued SFAS No. 141(revised2007) (“SFAS 141R”), a revision of SFAS 141, *BusinessCombinations*.   SFAS 141Restablishes requirements for the recognition and measurement of acquiredassets, liabilities, goodwill, and non-controlling interests. SFAS 141Ralso provides disclosure requirements related to business combinations. SFAS 141Ris effective for fiscal years beginning after December 15, 2008.SFAS 141R will be applied prospectively to business combinations with anacquisition date on or after the effective date.

 

7.               Commitments and Contingencies

 

We are subject to legal proceedingsand claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward LookingStatements

 

This Quarterly Report on Form 10-Q,including, without limitation, the section entitled “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934. Such forward-looking statements are generally accompanied by words suchas “estimate,” “expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may”or other words that convey uncertainty of future events or outcomes.  These statements relate to future events orto our future financial performance, and involve known and unknown risks,uncertainties and other factors that may cause our actual results, levels ofactivity, performance, or achievements to be materially different from any futureresults, levels of activity, performance or achievements expressed or impliedby these forward-looking statements. Factors that may cause actual results todiffer materially from current expectations, which we describe in more detailelsewhere in this Quarterly Report on Form 10-Q  under the heading “Factors That May AffectFuture Results of Operations,” and in our 2007 Annual Report on Form 10-KSBin “Item 1 – Description of Business” include, but are not limited to:

 

·                  insufficient cash to operate ourbusiness and inability to meet our liquidity requirements;

 

·                  loss of revenues due to the failureof our newer products to achieve market acceptance;

 

·                  our need to generate substantiallygreater revenues from sales in order to achieve profitability;

 

·                  concentration of our revenues fromU.S. government entities and the possibility of loss of one of these customersand the  unique risks associated withgovernment customers;

 

·                  our dependence on sales made throughindirect channels;

 

·                  the challenge of selling our productsinternationally;

 

·                  our dependence on equity or debtfinancing provided primarily by our Chief Executive Officer in order to meetour cash flow requirements;

 

·                  the effect that payment of accrueddividends on our preferred stock has on our cash resources and the substantialdilution upon the conversion or redemption of our preferred stock and exerciseof outstanding warrants;

 

·                  the impact of conversion of preferredstock or exercise of warrants on the price of our common stock;

 

·                  the ability of our preferredstockholders and lenders to hinder additional financing; and

 

·                  the influence that our management andlarger stockholders have over actions taken by the company.

 

If one or more ofthese or other risks or uncertainties materialize, or if our underlyingassumptions prove to be incorrect, actual results may vary significantly fromwhat we projected. These forward-looking statements and other statements madeelsewhere in this report are made in reliance on the Private SecuritiesLitigation Reform Act of 1995.  Anyforward-looking statement you read in this Quarterly Report on Form 10-Qor our Annual Report on Form 10-KSB reflects our current views withrespect to future events and is subject to these and other risks, uncertaintiesand assumptions relating to our operations, results of operations, growthstrategy and liquidity. We assume no obligation to publicly update or revisethese forward-looking statements for any reason, or to update the reasonsactual results could differ materially from those anticipated in theseforward-looking statements, even if new information 

 

8

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becomes available in thefuture.  The section below entitled “FactorsThat May Affect Future Results of Operations” sets forth and incorporatesby reference certain factors that could cause actual future results of theCompany to differ materially from these statements.

 

Critical Accounting Policiesand Estimates

 

Management’s discussion andanalysis of financial condition and results of operations are based upon ourunaudited condensed consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

 

*Revenue Recognition*

 

We generally recognize product revenue upon shipment of product. Weaccrue for estimated warranty costs and sales returns at the time of shipmentbased on our experience. Revenue from maintenance contracts is deferred andrecognized over the contractual period the services are performed, generallyone year.  There is a risk that technicalissues on new products could result in unexpected warranty costs andreturns.  However, as we migrate to moreof a software-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followingcriteria have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectability is probable. Bundled hardware andperpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and we begin to offer licenses on asubscription basis, we would perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easilyobtained for all of our product offerings, as we have historical salesinformation on our product offerings.  Wedefer and recognize maintenance and support revenue over the term of thecontract period, which is generally one year.

 

We have signed distribution agreements with distributors in the UnitedStates, Europe and Asia. In general, these relationships are non-exclusive.

 

We generally recognize service revenue upon delivery of the contractedservice.  Service revenue, primarilyincluding maintenance, training and installation, are recognized upon deliveryof the service and typically are unrelated to product sales.  These services are not essential to the functionalityof the delivered product.  To date,training and installation revenue has not been material.

 

*Allowance for Doubtful Accounts and Returns*

 

We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments. Ourreceivables are uncollaterized and we expect to continue this policy in thefuture.  If the financial condition ofour customers were to deteriorate, resulting in an impairment of their abilityto make payments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

 

*Inventory*

 

We write down our inventory for estimated obsolescence or unmarketableinventory equal to the difference between the cost of inventory and theestimated market value based upon assumptions about future demand and marketconditions. If actual market 

 

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conditions are less favorable than those projected by management,additional inventory write-downs may be required.   Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

 

Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007** | ** ** |
| Net product revenue                               |       | 64.7                             | %          | 82.3 | % |
| Net customer support and maintenance  revenue     |       | 35.3                             |       | 17.7 |   |
| Total revenue                                     |       | 100.0                            | %          | 100.0 | % |
| Cost of product revenue                           |       | 37.6                             |       | 36.9 |   |
| Cost of customer support and maintenance  revenue |       | 1.2                              |       | 1.7 |   |
| Total cost of revenue                             |       | 38.8                             | %          | 38.6 | % |
| Gross profit                                      |       | 61.2                             | %          | 61.4 | % |
| Operating expenses:                               |       |                             |       |   |   |
| Sales and marketing                               |       | 80.3                             |       | 47.1 |   |
| Research and development                          |       | 111.5                            |       | 38.7 |   |
| General and administrative                        |       | 57.4                             |       | 20.8 |   |
| Operating loss                                    |       | (188.0                           | )%         | (45.2 | )% |
|                                              |       |                             |       |   |   |
| Interest income, net                              |       | (1.2                             | )          | 0.1 |   |
| Loss before income tax provision                  |       | (189.2                           | )%         | (45.1 | )% |
|                                              |       |                             |       |   |   |
| Income tax provision                              |       | —                           |       | — |   |
|                                              |       |                             |       |   |   |
| Net loss                                          |       | (189.2                           | )%         | (45.1 | )% |
| Preferred stock dividends accrued                 |       | (8.7                             | )          | (3.9 | ) |
| Beneficial conversion feature on preferred  stock |       | —                           |       | — |   |
|                                              |       |                             |       |   |   |
| Net loss attributable to common  stockholders     |       | (197.9                           | )%         | (49.0 | )% |

 
| ** **         | ** ** | **Three Months Ended** | ** ** |
|--------------------|------------|----------------------------------|------------|
| ** **         | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007** | ** ** |
| Domestic revenue   |       | 84.6                             | %          | 88.0 | % |
| Export revenue to: |       |                             |       |   |   |
| Europe             |       | 14.0                             |       | 11.1 |   |
| Canada             |       | 0.1                              |       | 0.1 |   |
| Asia               |       | 0.9                              |       | 0.8 |   |
| Latin America      |       | 0.4                              |       | 0.0 |   |
|               |       |                             |       |   |   |
| Net revenue        |       | 100.0                            | %          | 100.0 | % |

 

**Net Revenue**.  Totalrevenue for the quarter ended March 31, 2008 was $0.5 million, compared to$1.1 million for the same period in 2007. Product revenue decreased $0.6 million for the quarter ended March 31,2008 compared to the same period in 2007. The decline in product revenue isrelated to shifting our focus from our SecureNet IPS product line to ourCompliance Commander and TraceCop product lines.  Also, a delay in government funding ofcertain government projects, which we currently project to receive in thesecond quarter of 2008, contributed to the decrease in TraceCop product linesales.  Customer support and maintenancerevenue decreased $31 thousand for the quarter ended March 31, 2008compared to the same period in 2007. This decline is mainly due to the expiration of maintenance contractsrelated to our SecureNet product line. We expect our product revenue to increase in the future as the marketacceptance of our Compliance Commander and TraceCop product lines increase.

 

**Concentrationof Revenue**.  Revenue from sales to various U.S. governmententities totaled $0.3 million, or 59.6 % of revenue, for the quarter ended March 31,2008 compared to $0.8 million, or 70.5% of revenue, for the same period in2007.  Although we expect ourconcentration of revenue to vary among customers in future quarters dependingupon the timing of certain sales, we anticipate that sales to governmentcustomers will continue to account for a significant portion of our revenue infuture quarters as sales of our TraceCop product lines increase.  Sales to the government present risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenue, including potential disruption to appropriation andspending patterns and the government’s reservation of the right to cancelcontracts and purchase orders for its convenience.  Although we do not believe 

 

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that any of our revenue withgovernment customers are subject to renegotiation, a large number of cancelledor renegotiated government orders could have a material adverse effect on ourfinancial results.  Currently, we are notaware of any proposed cancellation or renegotiation of any of our existingarrangements with government entities and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

 

**GrossProfit**.  Gross profit was $0.3 million or 61.2%of net revenues for the quarter ended March 31, 2008, compared to $0.7million or 61.4% of net revenues for the same period in 2007. Gross profitmargins as a percentage of net revenues slightly decreased from the same periodin the prior year due to an unfavorable shift in product mix.  Gross profit on product revenues for thequarter ended March 31, decreased from 55.1% in 2007 to 41.8% in 2008mainly a result of lower revenue levels. Gross profit on customer support and maintenance revenue for the quarterended March 31, increased from 90.7% in 2007 to 96.6% in 2008.

 

Gross profit as a percentageof net revenue is impacted by several factors, including shifts in product mix,changes in channels of distribution, revenue volume, fluctuations inthird-party assembly costs, pricing strategies, and fluctuations in revenues ofintegrated third-party products.

 

**Sales andMarketing**.  Sales and marketing expenses decreasedto $0.4 million or 80.3% of net revenues for the quarter ended March 31,2007 compared to $0.5 million or 47.1% of net revenues in 2007 primarily due toa planned reduction in sales related expenses. Sales and marketing expenses may vary in the future, mainly dependant onrevenue levels; however, we believe that these costs will remain relativelyconstant through the end of 2008.

 

**Researchand Development**.  Research and development expensesincreased to $0.5 million or 111.5% of net revenues for the quarter ended March 31,2008 from $0.4 million or 38.7% of net revenues for the same period in 2007.Research and development costs are expensed in the period incurred.  Research and development expenses increaseddue to less expenses shifting from R&D expenses to cost of sales inrelation to engineering contract jobs. Research and development expenses may vary in the future; however, webelieve that these costs will remain relatively constant through the end of2008.

 

**General andAdministrative**.  General and administrative expenses increasedto $0.3 million for the quarter ended March 31, 2008, compared to $0.2million for the quarter ended March 31, 2007.  Itis expected that general and administrative expenses will remain relativelyconstant throughout the remainder of 2008, as no further cost reductions areanticipated.  General and administrativeexpense may vary in the future.

 

**Interest**.  Netinterest expense was $6,000 for the quarter ended March 31, 2008 comparedto income of $2,000 for the same period in 2007.  The decrease in interest income was primarilydue to a decrease of cash and short-term investment balances when compared tothe prior year as well as interest expense for financing obtained during thequarter ended March 31, 2008.  Netinterest income may vary in the future based on our cash flow and rate ofreturn on investments.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at March 31, 2008 is approximately $93 thousand of cash and cashequivalents.  At March 31, 2008there was a working capital deficiency of $1.3 million compared to a surplus of$0.5 million at March 31, 2007.

 

Cash used in operationsfor the three months ended March 31, 2008 was $0.9 million, primarily dueto a net loss of $0.9 million and an increase in accounts receivable of $53thousand.  This cash decrease waspartially offset by depreciation expense of $12 thousand, stock-basedcompensation expense of $5 thousand, a decrease in inventories of $24 thousand,a decrease in prepaid expenses and other assets of $11 thousand, a decrease inaccounts payable and accrued expenses of $33 thousand, and an increase indeferred revenue of $21 thousand.  Cashused in operations for the three months ended March 31, 2007 was $0.6million, primarily due to a net loss of $0.5 million, a decrease in accountspayable and accrued expenses of $216 thousand, a reduction in deferred revenueof $16 thousand, and a reduction in the provision for doubtful accounts of $14thousand.  This cash decrease waspartially offset by stock-based compensation expense of $8 thousand,depreciation expense of $17 thousand, a decrease in accounts receivable of $49 thousand,and a decrease in prepaid expenses and other assets of $42 thousand.

 

There was nocash used in investing activities in the three months ended March 31, 2008for net purchases of property and equipment, compared to $27 thousand of cashused in investing activities in the three months ended March 31, 2007.

 

Cash provided in financingactivities in the three months ended March 31, 2008 was $0.6 million,primarily consisting of the proceeds from the issuance of a promissory note for$0.7 million to an officer and disbursements under the line of credit of $86thousand, compared to cash used in financing activities in the three monthsended March 31, 2007 was $0.4 million, primarily consisting of theproceeds from the issuance of common stock of $0.5 million, payment ofdividends on preferred stock of $27 thousand and net activity under the line ofcredit of $75 thousand.

 

At March 31, 2008,the Company did not have any material commitments for capital expenditures.

 

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During the three monthsended March 31, 2008, the Company funded its operations through the use ofcash and cash equivalents and borrowings of $705,000 from our CEO, G. WardPaxton.

 

On March 29, 2006, we established a $1.0 million line of creditwith Silicon Valley Bank.  Under theterms of this agreement, we may borrow an amount equal up to 80% of eligibleaccounts receivable balances.  Inaddition, we may obtain inventory advances equal to 35% of finished goodinventory, capped at the lesser of the inventory availability, $300,000 or 35%of our total borrowing base.  If ourcredit line increases to $2.0 million, inventory advances will be capped at thelesser of the inventory availability, $600,000 or 35% of our borrowingbase.  Amounts we borrow under the creditline accrue interest at an annual rate of prime plus 1% and are secured by alien on all of our assets.  Accruedinterest on all outstanding amounts is payable monthly in arrears and all outstandingprincipal and accrued but unpaid interest on the amounts we borrow are due on June 28,2008.  Our ability to receive advancesunder this credit line will increase if we generate additional receivables andinventory from the sale of our products. We have $14,000 outstanding under this credit line as of March 31,2008.  Also, at March 31, 2008, wecould borrow an additional $31,000 based on our borrowing basecalculation.  The line of credit wasextended on March 28, 2008 until June 28, 2008.  Accrued interest on all outstanding amountsis payable monthly in arrears and all outstanding principal and accrued butunpaid interest on the amounts we borrow are due on June 28, 2008.  At or before June 28, 2008, it isanticipated, though not assured, that we will put a new credit facility inplace with Silicon Valley Bank.

 

Net operating losses and operating cash outflows may continue throughthe second quarter of 2008 and possibly later into the fiscal year 2008.  The sufficiency of our cash resources maydepend to a certain extent on general economic, financial, competitive or otherfactors beyond our control.  In addition,we are obligated to make payments of accrued dividends on all our outstandingshares of preferred stock that will reduce our available cash resources.   As of March 31, 2008 we had cash andcash equivalents of $93,000 and $31,000 available funding under our line ofcredit at Silicon Valley Bank and $1.5 million available from a writtencommitment to invest up to $1.5million from G. Ward Paxton, the Company’s Chairman, President and ChiefExecutive Officer.  Basedon projections for increased revenues in 2008 and a commitment from the Company’sCEO to advance the Company up to $1.5 million in additional funding should itbe necessary, we believe that our available credit line and available cashresources will provide sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months.  Weexpect to fund our operations through additional investments of private equityand debt, which, if we are able to obtain, will have the effect of diluting ourexisting common stockholders, perhaps significantly.  Any equity or debt financings, if availableat all, may be on terms which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders. If ouroperations do not generate positive cash flow in the next few months, or if weare not able to obtain additional debt or equity financing on terms andconditions acceptable to us, if at all, we may be unable to implement ourbusiness plan, fund our liquidity needs or even continue our operations.

 

We may explore the possibleacquisitions of businesses, products and technologies that are complementary toour existing business.  We are continuingto identify and prioritize additional security technologies, which we may wishto develop, either internally or through the licensing, or acquisition ofproducts from third parties.  While wemay engage from time to time in discussions with respect to potentialacquisitions, there can be no assurances that any such acquisitions will bemade or that we will be able to successfully integrate any acquiredbusiness.  In order to finance suchacquisitions and working capital it may be necessary for us to raise additionalfunds through public or private financings. Any equity or debt financings, if available at all, may be on terms,which are not favorable to us and, in the case of equity financings, may resultin dilution to our stockholders.

 

Item 4T.                        CONTROLS AND PROCEDURES

 

Wemaintain “disclosure controls and procedures,” as defined in Rule 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), that are designed to ensure that information required to be disclosed byus in reports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our principal executive officer and principal financialofficer, as appropriate, to allow timely decisions regarding requireddisclosure.  In designing and evaluatingour disclosure controls and procedures, management recognized that disclosurecontrols and procedures, no matter how well conceived and operated, can provideonly reasonable assurance of achieving the desired control objectives, and wenecessarily are required to apply our judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures.

 

Ourmanagement, including our principal executive officer and principal financialofficer, evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures as of March 31, 2008 and concluded thatthe disclosure controls and procedures were effective.

 

Therehave not been any changes in our internal control over financial reporting thatoccurred during the quarter ended March 31, 2008 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II – OTHER INFORMATION**

 

Item1A.                                                   RISK FACTORS

 

**Factors That May Affect Future Resultsof Operations**

 

We are providing the following information regarding changes that haveoccurred to previously disclosed risk factors from our Annual Report on Form 10-KSBfor the year ended December 31, 2007. In addition to the other information set forth below and elsewhere inthis report, you should consider the factors discussed under the heading “FactorsThat May Affect Future Results of Operations” in our Form 10-KSB forthe year ended December 31, 2007. The risks described in our Quarterly Reports on Form 10-Q are notthe only risks facing our Company. Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.

 

***Ourcash, cash equivalents, and investments decreased from $0.4 million at December 31,2007 to $0.1 million at March 31, 2008. As a result of our expected continuing net cash outflows, we may nothave sufficient cash to operate our business and may not be able to maintaincertain liquidity requirements. Additional debt and equity offerings to fund future operations may not beavailable and, if available, may significantly dilute the value of ourcurrently outstanding common stock.***

 

As of March 31, 2008, we had cash, cash equivalents andinvestments of approximately $0.1 million, down from approximately $0.4 millionas of December 31, 2007.  Netoperating losses and operating cash outflows may continue through the secondquarter of 2008 and possibly later into fiscal year 2008.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  As of March 31, 2008 we had cash and cash equivalents of $93,000and $31,000 available funding under our line of credit at Silicon Valley Bankand $1.5 million available from a written commitment to invest up to $1.5 million from G. Ward Paxton,the Company’s Chairman, President and Chief Executive Officer.  We expect to fund our operationsthrough additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe next few months, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

***Ourrevenues declined from $1.1 million in the first quarter 2007 to $0.5 millionin the first quarter 2008 as a continuing effect from the shift in focus fromSecureNet products to Compliance Commander and TraceCop products.   If our newer products do not achieve marketacceptance, our revenues will continue to suffer.***

 

We have transitioned oursales strategy focus from SecureNet to Compliance Commander and TraceCop.  During this transition, sales of our newerproducts did not offset the losses in sales associated with our olderproducts.  As a result, our net revenuedeclined from $1.1 million in the first quarter 2007 to $0.5 million in thefirst quarter 2008, continuing the decline in fiscal year 2007 from fiscal year2006.  We can provide no assurances thatsales of our newer products will ever offset the losses in sales of olderproducts or generate sufficient revenues to sustain our business.

 

Our new network securityproducts, regulated information compliance systems and entity identificationproducts have only been in the market place for a limited period of time andmay have longer sales cycles than our previous products.  Accordingly, we may not achieve themeaningful revenue growth needed to sustain operations.  If we are unable to recognize revenues due tolonger sales cycles or other problems, our results of operations will beadversely affected, perhaps materially.

 

We have not yet receivedbroad market acceptance for our newer products. We cannot assure you that our present or future products will achievemarket acceptance on a sustained basis. In order to achieve market acceptance and achieve future revenue growth,we must introduce complementary security products, incorporate new technologiesinto our existing product lines and design, develop and successfullycommercialize higher performance products in a timely manner.  We cannot assure you that we will be able tooffer new or complementary products that gain market acceptance quickly enoughto avoid decreased revenues during current or future product introductions ortransitions.

 

***Wehad a net loss of $0.9 million for the quarter ended March 31, 2008 andhave an accumulated deficit of $58.3 million as of March 31, 2008.  To achieve profitability, we must generatesubstantially greater revenues.***

 

We incurred significantoperating losses for the quarter ended March 31, 2008 and have incurredoperating losses in previous years.  Forthe year ended December 31, 2007, we incurred a net loss of $2.4 millionand had an accumulated deficit of approximately $57.5 million as of December 31,2007. ** **Weneed to generate and sustain substantially greater revenues from the sales ofour products

 

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if we are to achieveprofitability.  If we are unable toachieve these greater revenues, our losses will continue for the near term andpossibly longer, and we may never achieve or sustain profitability or generatepositive cash flow from operations.

 

***A large percentage of our revenues are received from U.S.government entities, and the loss of one of these customers could reduce ourrevenues and materially harm our business and prospects.***

 

                                                A largepercentage of our revenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the quarter ended March 31,2008, sales to U.S. government entities collectively accounted for 59.6% of ourrevenues.  For the years ended December 31,2005, 2006****and 2007, sales to U.S.government entities collectively accounted for 70.7%, 73.6% and 73.2% of ourtotal net revenues, respectively. The loss of any of these key relationshipsmay send a negative message to other U.S. government entities ornon-governmental customers concerning our product offering. We cannot assure you that U.S. government entities will be customersof ours in future periods or that we will be able to diversify our customerportfolio to adequately mitigate the risk of loss of any of these customers.

 

***Government customers involve unique risks, which couldadversely impact our revenues.***

 

We expect to continue toderive a substantial portion of our revenues from U.S. government customers inthe future.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customers,including potential disruption due to appropriation and spending patterns,delays in approving a federal budget and the government’s right to cancelcontracts and purchase orders for its convenience.  A delay in government funding of certain governmentprojects, which we currently project to receive in the second quarter of 2008,was attributable to a decrease in TraceCop product line sales in the firstquarter of 2008.  General political andeconomic conditions, which we cannot accurately predict, directly andindirectly may affect the quantity and allocation of expenditures by federaldepartments.  In addition, obtaininggovernment contracts may involve long purchase and payment cycles, competitivebidding, qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulationswith which we must comply and which can vary significantly amongdepartments.  As a result, cutbacks orre-allocations in the federal budget or losses of government sales due to otherfactors could have a material adverse effect on our revenues and operatingresults.

 

***Weare highly dependent on sales made through indirect channels, the loss of whichwould materially adversely affect our operations.***

 

We derived 16.2%of revenue in the first quarter of 2008 from such sales channels.  For the years ended December 31, 2005,2006 and 2007, we derived 36.2%, 17.3% and 19.2% of our revenues from salesthrough indirect sales channels, such as distributors, value-added resellers,system integrators, original equipment manufacturers and managed serviceproviders.  We must expand our salesthrough these indirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

***International sales comprise a material portion of ouroverall revenues.  Our ability to sellour products internationally is subject to certain risks, which could harm ourbusiness.***

 

Foreign sales in thefirst quarter of 2008 were 15.4% of revenue. Revenues from foreign customers for the fiscal years ended December 31,2005, 2006 and 2007 accounted for approximately 10.7%, 9.4% and 9.2%,respectively, of our revenue.  We expectsales to foreign customers to continue to represent a significant portion ofour revenues in the future.  Ourinternational operations are subject to many inherent risks that may adverselyaffect our business, financial condition and operating results, including:

 

·                  political,social and economic instability;

 

·                  traderestrictions;

 

·                  increases induty rates and other potentially adverse tax consequences;

 

·                  exposure todifferent legal standards, particularly with respect to the protection ofintellectual property;

 

·                  burdens ofcomplying with a variety of foreign laws;

 

·                  unexpectedchanges in regulatory requirements;

 

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·                  import andexport license requirements and restrictions of the United States and eachother country where we operate;

 

·                  fluctuations incurrency exchange rates; and

 

·                  changes in localpurchasing practices, including seasonal fluctuations in demand.

 

Any interruptionsor declines in our international sales would result in a significant adverseimpact on our results of operations and business.

 

***The payment of accrued dividends on our preferred stock maystrain our cash resources.***

 

On March 25,2004, we completed a $5,000,000 private placement pursuant to which we issued1,000,000 shares of our 5% Convertible Preferred Stock (the “Series 1Preferred Stock”) and warrants to acquire 556,619 shares of our commonstock.  The conversion price for the Series 1Preferred Stock and the exercise price of the warrants is $3.144 pershare.  As of April 30, 2008, therewere 259,696 shares of the Series 1 Preferred Stock outstanding,representing approximately 413,003 shares of common stock upon conversion.

 

On March 28,2005, we completed a $2,663,000 private placement pursuant to which we issued1,065,200 shares of our Series 2 5% Convertible Preferred Stock (the “Series 2Preferred Stock”) and warrants to acquire 532,600 shares of our commonstock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of April 30,2008, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion.

 

On December 2, 2005, we completed a $1,230,843 private placementpursuant to which we issued 564,607 shares of our Series 3 5% preferredstock  (the “Series 3 PreferredStock”) and warrants to acquire 282,306 shares of our common stock. .Thepreferred shares may be converted into 564,607 shares of common stock at aninitial conversion price of $2.18 per share, and the warrants may be exercisedat a price of $0.40 per share during the five-year period commencing on June 2,2006.  As of April 30, 2008, therewere 354,056 shares of Series 3 Preferred Stock outstanding, representing354,056 shares of common stock upon conversion.

 

During the quarterended March 31, 2008, we accrued $16,000 in dividends to the holders ofour 5% Preferred Stock, $14,000 in dividends to the holders of our Series 25% Preferred Stock and $10,000 in dividends to the holders of our Series 35% Preferred Stock.

 

Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and as of March 31,2008, did not have sufficient capital surplus, defined as the amount by whichour net assets exceed our stated capital, based on par value of our outstandingshares as provided by Delaware law.  Wecannot assure you that our net assets will exceed our stated capital or that wewill have net profits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  The accrual of thesedividends may adversely affect our operating results.  Moreover, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business.

 

If we are unableto pay dividends on our preferred stock, we will accrue an additional late feepenalty of 18% per annum on the unpaid dividends for the Series 2Preferred Stock and Series 3 Preferred Stock, and we could be required toredeem the outstanding shares of Series 2 Preferred Stock and Series 3Preferred Stock for shares of our common stock issued at a price equal to 75%of the average of the volume weighted average price of our common stock for theten days ending on the day immediately preceding an election to redeem,subject, in the case of the Series 3 Preferred Stock, to a floor of$0.87.  As a result, the issuance orpotential issuance of these additional shares of common stock could cause ourstock price to decline.  Furthermore, ourinability to pay dividends could adversely affect our ability to raise equityfinancing in the future if required.

 

***Youwill experience substantial dilution upon the conversion or redemption of theshares of preferred stock and the exercise of warrants that we issued in ourrecent private placements or in the event we raise additional funds through theissuance of new shares of our common stock or securities convertible orexercisable into shares of common stock.***

 

On April 30,2008, we had 11,638,405 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have14,389,318 shares of common stock outstanding, approximately a 25.0% increasein the number of shares of our common stock outstanding.

 

Further, theoccurrence of certain events could entitle holders of our Series 2 PreferredStock and Series 3 Preferred Stock to require us to redeem their sharesfor a certain number of shares of our common stock.  Assuming (i) we have paid all liquidated

 

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damages and other amountsto the holders, (ii) incurred accrued but unpaid dividends on April 30,2008 of $92,000, (iii) a volume weighted average price of $0.16, which wasthe ten-day volume weighted average closing price of our common stock on April 30,2008, and (iv) our 11,638,405 shares of common stock outstanding on April 30,2008, upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 21,488,563 shares of our common stock.  This would represent an increase ofapproximately 184.6% in the number of shares of our common stock as of April 30,2008.

 

In addition,management may issue additional shares of common stock or securitiesexercisable or convertible into shares of common stock in order to finance ourcontinuing operations.  Any futureissuances of such securities would have additional dilutive effects on theexisting holders of our Common Stock.

 

***Theconversion of preferred stock or exercise of warrants we issued in the privateplacements may cause the price of our common stock to decline.***

 

The holders of the sharesof our 5% Preferred Stock and warrants we issued in connection with the sale ofour 5% Preferred Stock may freely convert their shares of preferred stock and exercisetheir warrants and sell the underlying shares of common stock pursuant to Rule 144of the Securities and Exchange Commission. As of April 30, 2008, 740,304 shares of our 5% Preferred Stock hadconverted into 1,177,327 shares of common stock.

 

The holders of the sharesof Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 Preferred Stock may freely convert their sharesof preferred stock and exercise their warrants and sell the underlying sharesof common stock pursuant to Rule 144 of the Securities and ExchangeCommission.  As of April 30, 2008,605,200 shares of Series 2 Preferred Stock had converted into 605,200shares of common stock.

 

The holders of the sharesof Series 3 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 3 Preferred Stock, may freely convert their sharesof Series 3 Preferred Stock and exercise their warrants and sell theunderlying shares of common stock pursuant to Rule 144 of the Securitiesand Exchange Commission.  As of April 30,2008, 210,551 shares of Series 3 Preferred Stock had converted into210,551 shares of common stock.

 

For the four weeks endedon April 30, 2008, the average daily trading volume of our common stock onThe OTCBB was 2,756 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants and sell a material amount oftheir underlying shares of common stock on the open market, the increase inselling activity could cause a decline in the market price of our commonstock.  Furthermore, these sales, or thepotential for these sales, could encourage short sales, causing additionaldownward pressure on the market price of our common stock.

 

***Certainrights of the holders of our preferred stock and the terms of our securedcredit line may hinder our ability to raise additional financing.***

 

Under the terms ofour preferred stock instruments, we cannot issue shares of capital stock withrights senior to those of our existing 5% Preferred Stock, Series 2 5%Preferred Stock or Series 3 5% Preferred Stock without the approval of atleast a majority of the holders of our 5% Preferred Stock, all of the holdersof our Series 2 5% Preferred Stock, and holders of at least 75% of our Series 35% Preferred Stock voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of each class of ourPreferred Stock.  Furthermore, the termsof our secured credit line with Silicon Valley Bank include covenants whichrestrict our ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

 

***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

 

Since we beganrestructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. We have alsoimplemented other strategic initiatives, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

***Weresemble a developmental stage company and our business strategy may not besuccessful.***

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions.  We now depend exclusively on revenuesgenerated from the sale of our network security products, which have receivedlimited market acceptance.  We haverecently 

 

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introduced our regulatedinformation compliance systems and entity identification products, and themarket for these products has only begun to emerge.  We can provide no assurances that our newlyintroduced products will ever achieve widespread market acceptance or that anadequate market for these products will ever emerge.  Consequently, we resemble a developmentalstage company and will face the following inherent risks and uncertainties:

 

·                  the need for ournetwork security products, regulated information compliance systems and entityidentification products to achieve market acceptance and produce a sustainablerevenue stream;

 

·                  our ability tomanage costs and expenses;

 

·                  our dependence onkey personnel;

 

·                  our ability toobtain financing on acceptable terms; and

 

·                  our ability tooffer greater value than our competitors.

 

Our businessstrategy may not successfully address these risks.  If we fail to recognize significant revenuesfrom the sales of our network security products, regulated informationcompliance systems and entity identification products, our business, financialcondition and operating results would be materially adversely affected.

 

***Our management and larger stockholders exercise significantcontrol over our company and have the ability to approve or take actions thatmay be adverse to your interests.***

 

As of April 30,2008, our executive officers, directors and preferred stockholders beneficiallyown approximately 38.7% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, we contemplate the possible issuanceof shares of our Common Stock or of securities exercisable or convertible intoshares of our Common Stock in the future by our Chief Executive Officer.  Any such issuance will increase thepercentage of stock our Chief Executive Officer and our management group beneficiallyholds.

 

***We face intense competition from both start-up andestablished companies that may have significant advantages over us and ourproducts.***

 

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Our principal competitors in the network intrusion prevention anddetection market include Internet Security Systems, Inc. (IBM), CiscoSystems, Inc., Symantec, Inc., Juniper Networks, Inc., McAfeeInc., Tipping Point Technologies, a division of 3Com Corporation, and NFRSecurity, Inc.  Our competitors inthe regulated information compliance market include Vontu (Symantec), PortAuthority (Websense), Vericept, Reconnex, Tablus and a small number of start-upcompanies that entered the space within the last two years. Our current andpotential competitors may have one or more of the following significantadvantages over us:

 

·                  greaterfinancial, technical and marketing resources;

 

·                  better namerecognition;

 

·                  morecomprehensive security solutions;

 

·                  better or moreextensive cooperative relationships; and

 

·                  larger customerbase.

 

We cannot assure you thatwe will be able to compete successfully with our existing or newcompetitors.  Some of our competitors mayhave, in relation to us, one or more of the following: longer operatinghistories, longer-standing relationships with OEM and end-user customers andgreater customer service, public relations and other resources. As a result,these competitors may be able to more quickly develop or adapt to new oremerging technologies and changes in customer requirements, or devote greaterresources to the development, promotion and sale of their products.Additionally, it is likely that new competitors or alliances among existingcompetitors could emerge and rapidly acquire significant market share.

 

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***If we fail to respond to rapid technological changes in thenetwork security industry, we may lose customers or our products may becomeobsolete.***

 

The network securityindustry is characterized by frequent product introductions, rapidly changingtechnology and continued evolution of new industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our existingproducts that meet changing customer requirements and evolving industrystandards. The development of technologically advanced network securityproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new orenhanced products successfully in a timely manner.  Further, we or our competitors may introducenew products or product enhancements that shorten the life cycle of ourexisting products or cause our existing products to become obsolete.

 

***Our products are highly technical and if theycontain undetected errors, our business could be adversely affected and wemight have to defend lawsuits or pay damages in connection with any alleged oractual failure of our products and services.***

 

Our products arehighly technical and complex, are critical to the operation of many networksand, in the case of our security products, provide and monitor network securityand may protect valuable information. Our products have contained and maycontain one or more undetected errors, defects or security vulnerabilities.Some errors in our products may only be discovered after a product has beeninstalled and used by end customers. Any errors or security vulnerabilitiesdiscovered in our products after commercial release could result in loss ofrevenues or delay in revenue recognition, loss of customers and increasedservice and warranty cost, any of which could adversely affect our business andresults of operations. In addition, we could face claims for product liability,tort or breach of warranty. Defending a lawsuit, regardless of its merit, iscostly and may divert management’s attention. In addition, if our businessliability insurance coverage is inadequate or future coverage is unavailable onacceptable terms or at all, our financial condition could be harmed.

 

***Abreach of network security could harm public perception of our securityproducts, which could cause us to lose revenues.***

 

If an actual orperceived breach of network security occurs in the network of a customer of oursecurity products, regardless of whether the breach is attributable to ourproducts, the market perception of the effectiveness of our products could beharmed. This could cause us to lose current and potential end customers or causeus to lose current and potential value-added resellers and distributors.Because the techniques used by computer hackers to access or sabotage networkschange frequently and generally are not recognized until launched against atarget, we may be unable to anticipate these techniques.

 

***Ifour products do not interoperate with our customers’ networks, installationswill be delayed or cancelled and could harm our business.***

 

Our products aredesigned to interface with our customers’ existing networks, each of which havedifferent specifications and utilize multiple protocol standards and productsfrom other vendors. Many of our customers’ networks contain multiplegenerations of products that have been added over time as these networks havegrown and evolved. Our products will be required to interoperate with many orall of the products within these networks as well as future products in orderto meet our customers’ requirements. If we find errors in the existing softwareor defects in the hardware used in our customers’ networks, we may have tomodify our software or hardware to fix or overcome these errors so that ourproducts will interoperate and scale with the existing software and hardware,which could be costly and negatively impact our operating results. In addition,if our products do not interoperate with those of our customers’ networks,demand for our products could be adversely affected, orders for our productscould be cancelled or our products could be returned. This could hurt ouroperating results, damage our reputation and seriously harm our business andprospects.

 

***Whilewe believe that we currently have adequate internal control over financialreporting, we are exposed to risks from recent legislation requiring companiesto evaluate those internal controls.***

 

Section 404of the Sarbanes-Oxley Act of 2002 requires our management to report on theeffectiveness of our internal control over financial reporting. We have anongoing program to perform the system and process evaluation and testing necessaryto comply with these requirements. We have and will continue to incursignificant expenses and devote management resources to Section 404compliance on an ongoing basis. In the event that our chief executive officer,chief financial officer or independent registered public accounting firmdetermine in the future that our internal controls over financial reporting arenot effective as defined under Section 404, investor perceptions may beadversely affected and could cause a decline in the market price of our stock.

 

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***Our products can have long sales and implementation cycles,which may result in us incurring substantial expenses before realizing anyassociated revenues.***

 

The sale andimplementation of our products to large companies and government entitiestypically involves a lengthy education process and a significant technicalevaluation and commitment of capital and other resources.  This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect keyoperations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expendsignificant time and resources before we receive any revenues from a customeror potential customer.  Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

 

***Consolidation in the network security industry may limitmarket acceptance of our products.***

 

Several of ourcompetitors have acquired security companies with complementary technologies inthe past.  We expect consolidation in thenetwork security industry to continue in the future.  These acquisitions may permit our competitorsto accelerate the development and commercialization of broader product linesand more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market shares, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

 

***We must adequately protect our intellectual property inorder to prevent loss of valuable proprietary information.***

 

We rely primarily on acombination of copyright, trademark and trade secret laws, confidentialityprocedures and non-disclosure agreements to protect our proprietarytechnology.  However, unauthorizedparties may attempt to copy or reverse-engineer aspects of our products or toobtain and use information that we regard as proprietary.  Policing unauthorized use of our products isdifficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our intellectual property. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves to be inadequate or unenforceable, others may be able to useour proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

***We may incur substantial expenses defending ourselvesagainst claims of infringement.***

 

There are numerouspatents held by many companies relating to the design and manufacture ofnetwork security systems.  Third partiesmay claim that our products infringe on their intellectual propertyrights.  Any claim, with or withoutmerit, could consume our management’s time, result in costly litigation, causedelays in sales or implementations of our products or require us to enter intoroyalty or licensing agreements. Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license the infringedor similar technology on commercially reasonable terms could seriously harm ourbusiness.

 

***Fluctuations in our quarterly revenues may cause the priceof our common stock to decline.***

 

Our operating resultshave varied significantly from quarter to quarter in the past, and we expectour operating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Significant portions of our expenses are notvariable in the short term and we cannot reduce them quickly to respond to unexpecteddecreases in revenues.  Therefore, ifrevenues are below our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly, we may not attain positiveoperating margins in future quarters.  Anyof these factors could cause our operating results to be below the expectationsof securities analysts and investors, which likely would negatively affect theprice of our common stock.

 

***Theprice of our common stock has been volatile in the past and may continue to bevolatile in the future due to factors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, infiscal year 2007, the market price of our common stock on The OTCBB Marketfluctuated between $0.17 and $0.75 per share. The market price of our common stock may fluctuate significantly inresponse to a number of factors, many of which are outside our control,including:

 

·                  variations inour quarterly operating results;

 

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·                  changes inestimates of our financial performance by securities analysts;

 

·                  changes inmarket valuations of our competitors;

 

·                  announcements byus or our competitors of new products, significant contracts, acquisitions,strategic relationships, joint ventures or capital commitments;

 

·                  product ordesign flaws, product recalls or similar occurrences;

 

·                  additions ordepartures of key personnel;

 

·                  sales of commonstock in the future; and

 

·                  fluctuations instock market prices and volume, which can be particularly common among networksecurity and other high technology companies.

 

***Our past reductions in our work force may make it moredifficult for us to attract and retain the personnel necessary to successfullyoperate our business.***

 

We rely upon thecontinued service of a relatively small number of key technical, sales andsenior management personnel.  Our futuresuccess depends on retaining our key employees and our continuing ability toattract, train and retain other highly qualified technical, sales andmanagerial personnel.  We do not haveemployment agreements with our key technical, sales and senior managementpersonnel.  As a result, our employeescould resign with little or no prior notice. We may not be able to attract, assimilate or retain other highlyqualified technical, sales and managerial personnel in the future.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

 

***Ouracquisition of complementary products or businesses may adversely affect ourfinancial condition.***

 

We have made acquisitionsin the past and, in the future we may acquire or invest in additionalcompanies, business units, product lines or technologies to accelerate thedevelopment of products and sales channels complementary to our existingproducts and sales channels.  Negotiationof potential acquisitions and integration of acquired products, technologies orbusinesses could divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***Compliance with export regulations may hinder our sales toforeign customers.***

 

Certain of our datasecurity products incorporate encryption and other technology that may requireclearance and export licenses from the U.S. Department of Commerce under UnitedStates export regulations.  Any inabilityto obtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

 

***Provisionsof our charter documents and Delaware law may have anti-takeover effects.***

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions of Section 203of the Delaware General Corporation Law, which restricts certain businesscombinations with interested stockholders and could inhibit a non-negotiatedmerger or other business combination.

 

***Militaryactions may disrupt our business by reducing spending on our products,increasing our costs and affecting our international operations.***

 

United States militaryactions or other events occurring in response to or in connection with them,including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

 

·                  reducing ordelaying government, military or corporate spending on network securityproducts;

 

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·                  increasing thecost and difficulty in obtaining materials or shipping products; and

 

·                  affecting ourability to conduct business internationally.

 

Should theseevents occur, our business, operating results and financial condition could bematerially and adversely affected.

 

Item 6.                       EXHIBITS

 

Thefollowing Exhibits are filed with this report form 10-QSB:

 
| 31.1 | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                  |
|------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                  |
| 32.1 | Certification Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
| ** **              | **INTRUSION INC.**                                                        |
|-------------------------|---------------------------------------------------------------------------|
|                    |                                                                      |
| Date: May 14, 2008 | /s/  G. Ward Paxton                                                       |
|                    | G.  Ward Paxton                                                           |
|                    | Chairman,  President & Chief Executive Officer                   |
|                    | (Principal  Executive Officer)                                            |
|                    |                                                                      |
|                    |                                                                      |
| Date: May 14, 2008 | /s/  Michael L. Paxton                                                    |
|                    | Michael  L. Paxton                                                        |
|                    | Vice President, Chief  Financial Officer,  Treasurer & Secretary |
|                    | (Principal  Financial & Accounting Officer)                      |

 

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